This is an important essay for anyone who wants to understand banking.
The first bankers were goldsmiths, who owned safes in which to store the raw materials of their profession. Wealthy individuals paid goldsmiths a fee to store their gold, and goldsmiths issued them receipts. Eventually these individuals started using the warehouse receipts as fiduciary media; meaning that rather than go to the goldsmith and redeem one’s gold in order to purchase something, these individuals started endorsing over their warehouse receipts. Thusly, the warehouse receipts circulated in the economy rather than the gold itself. Over time the goldsmiths realized that they could issue warehouse receipts in excess of the gold held in their vaults and reap a profit, because at no time did all the people who owned warehouse receipts for gold travel to the bank at the same time to redeem their certificates for gold specie. Now, the goldsmiths did not simply spend the excess receipts on consumer goods; rather, they lent them to borrowers and earned interest. (Doubtless the goldsmiths and even some economists today do not consider this practice to be fraud.) Since there now were more warehouse receipts for gold circulating in the market than gold in the vault to back them, it was said that the gold reserves amounted to only a “fraction” of the outstanding claims.
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All would be well until the public became concerned that the bank had over-issued certificates. (Sometimes rumors were started by his competitors.) Then the holders of the certificates would “run” to the bank to redeem them for gold. A bank run had been born.
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Notice that the certificates backed 100% by gold could always be redeemed without any difficulty. Thusly, such money could never be the source of inflation or deflation. But the excess certificates were not back 100% by gold; they were backed by the promise of the borrower to repay–that is, this money was backed by DEBT! If the debt could not be repaid, these excess money certificates could not be redeemed for gold.
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Of course, money certificates today are backed by nothing—not gold, nor silver, nor cockleshells. The money we use is fiat money, and yet governments everywhere maintain the fiction that banks must hold reserves in some small percentage amount in order to cover their customers’ deposits. But what are these reserves? These reserves are debt, too.
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In the U.S. the only money that may be used legally “for all debts public and private” is a Federal Reserve note. These notes—the money we carry in our wallets—are referred to as “standard money”. There is no recourse to anything beyond these paper notes. If a person wished to “redeem” his Federal Reserve note, he could go to the nearest Federal Reserve Bank and redeem it for…another Federal Reserve note.
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If that person deposited his Federal Reserve note in a bank, the bank would create a demand deposit, also known as a checking account. The bank would send to the Federal Reserve Bank the Federal Reserve notes that it collected whose numbers were above what it deemed necessary to meet the normal needs of its customers for pocket cash. These notes would be deposited in the bank’s reserve account at the Fed. (A bank’s “reserve account” is nothing more than a checking account.) But the bank would not be required to maintain a 100% reserve account balance to match the total of all of its demand deposits. It is required to hold only a fraction in reserve–along a sliding scale, the fraction becoming greater for larger banks–to meet the withdrawal needs of its customers. The rest of his reserve account balance is “excess”, meaning not required to meet his “reserve requirement”.
So what can a bank do with its “excess reserves”? It can create a loan to another of its customers, credit that customer’s demand account, which will increase its reserve requirement and reduce its excess reserve position at the Fed by a fraction of the amount of the loan. The bank—actually, the banking system–can continue to lend and create demand deposits in this fashion until its reserve account balance matches its “reserve requirement”. This is how banks create money out of thin air, and one can readily understand the enormous ability of the banks to expand the money supply from this updated fractional reserve banking practice.
The key point is that the bank created the new demand deposit by creating a loan—the loan is an asset on the bank’s books and the demand deposit is a liability. Thusly, money in our bright new world of fractional reserve banking is backed by DEBT! In order for a deposit to be redeemed would require that the loan be repaid. If the loan cannot be repaid, the bank cannot meet its withdrawal obligations and goes bankrupt.
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Enter a new player–the central bank. Our Federal Reserve Bank (or European Central Bank, or Bank of England, or Bank of Japan, or Bank of China) was created to prevent bank insolvency. The central bank stands ready to loan our bank unlimited funds so that it may honor its deposit withdrawal obligations. . . . but where did the Fed get the funds to place in our troubled bank’s reserve account? Why, it created them out of thin air, too! . . . The central bank has become a money creation machine.
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Thusly, all central banks are the source of what the public calls inflation, creating money out of thin air to prop up bank credit expansion made possible by fractional reserve banking. The entire Rube Goldberg mechanism is a thing of frightening beauty, beloved by college professors who force their students to understand all the gory details, but especially beloved by bankers and politicians who can literally paper over bad debt with massive increases in the money supply. . . . The long-term harm to the economy is found on many fronts, from higher prices (perhaps even hyperinflation) to moral hazard to civic unrest as interest groups fight one another to feed at the government’s feed trough. Each dollar of new money, born of debt and not production, reduces the purchasing power of all other dollars already circulating in the economy. Nothing has been produced, not one nut or bolt, not one new car…nothing. But more money creates the temporary illusion of prosperity. One’s home increases in value. One’s 401K increases in value. Jobs are plentiful. New office buildings pop up to house all the new businesses that are born. The only problem is that nothing has been built on true savings, only debt. Yes, it is a brand new world, but it is a frightening one that cannot last.
(Read more from patrickbarron.blogspot.com)